Options Collars

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Options Collars

• Steve Meizinger
• ISE Education
• Education_at_ISEoptions.com

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Required Reading

• For the sake of simplicity, the examples that
  follow do not take into consideration commissions
  and other transaction fees, tax considerations,
  or margin requirements, which are factors that
  may significantly affect the economic
  consequences of a given strategy. An investor
  should review transaction costs, margin
  requirements and tax considerations with a broker
  and tax advisor before entering into any options
  strategy.
• Options involve risk and are not suitable for
  everyone. Prior to buying or selling an option,
  a person must receive a copy of CHARACTERISTICS
  AND RISKS OF STANDARDIZED OPTIONS. Copies have
  been provided for you today and may be obtained
  from your broker, one of the exchanges or The
  Options Clearing Corporation. A prospectus,
  which discusses the role of The Options Clearing
  Corporation, is also available, without charge,
  upon request at 1-888-OPTIONS or
  www.888options.com.
• Any strategies discussed, including examples
  using actual securities price data, are strictly
  for illustrative and educational purposes and are
  not to be construed as an endorsement or
  recommendation to buy or sell securities.

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Refresher

• Put options give holders the right to sell the
  stock at the strike price, but not the
  obligation, for that right they pay a premium
• Puts can insure portfolios although the cost of
  the put must be considered
• Call options give writers the obligation, but not
  the guarantee to sell the stock at the strike
  price for that obligation they receive a premium

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Altering risk/reward

• Is there a way to insure your stock/portfolio
  without buying the puts outright?

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Option Collar

• The Option Collar strategy is a protective
  strategy that allows investors to limit their
  downside risk by selling an upside call option
• Normally this strategy is employed subsequent to
  the purchase of the stock, thereby protecting the
  sale price of the stock

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Definition of Option Collars

• The purchase of a put and the simultaneous
  selling of a call
• The goal of an option collar is for downside
  protection with a minimal cost
• The economics of the trade depends on the price
  of the stock in relation to the downside put and
  the upside call sold and also the implied
  volatility of each

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Construction of a collar

• XYZ stock is trading 46.90 and investor is
  nervous about the next 53 days and a possible
  drop in the stock but does not want to sell the
  stock
• Action Buy 53 day 40 strike put (.75) and sell
  53 day 55 strike call (.60) for a total debit of
  .15

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Rights and Obligations

• Investor has the right to sell the stock with the
  purchase of the put option at 40 until
  expiration, 53 days in this example
• Investor has the obligation to sell the stock at
  55 if the call purchaser chooses to exercise any
  until expiration (53 days)

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Example of the collar at expiration
Stock at Expiration Cost of Collar Value of 55 Call sold Value of 40 Put bought Stock relative to 46.90 Profit Loss
60 -.15 -5 0 13.1 7.95
55 -.15 0 0 8.1 7.95
50 -.15 0 0 3.1 2.95
46.9 -.15 0 0 0 -0.15
45 -.15 0 0 -1.9 -2.05
40 -.15 0 0 -6.9 -7.05
35 -.15 0 5 -11.9 -7.05
30 -.15 0 10 -16.9 -7.05
25 -.15 0 15 -21.9 -7.05
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Collar risk-reward prior to expiration
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Risk-reward at expiration
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Components of collar

• Covered call (long stock with a call option
  sold), in this case 55 strike covered call in
  conjunction with a downside put for protection

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Advantages of Collars

• Guarantees minimum selling price during the life
  of the collar
• Relative low cost compared to outright put
  purchases
• Ownership of stock is maintained until exercise
  or assignment even though stock declines are
  being protected

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Disadvantages of a Collar

• Investor caps further stock appreciation to the
  upside call sold
• Modest downside risk is maintained although
  limited to the put strike held

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Collars act like spreads?

• If the call and put are the same expiration date
  the collar acts like a spread with clearly
  defined risk and reward tradeoffs
• Collars are a synthetic long call vertical
• A minimum and maximum value is created until
  expiration of the collar

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Why use collars?

• Bullish on a stock long term although nervous
  about the stock in the shorter term
• Do not want to pay for the puts outright, willing
  to finance them with the selling of call

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Options are about risk and return

• Collars are not free
• Question Would you be willing to have your
  stock called away at the strike price?

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Concentrated stock positions

• If an investor has a large position in one, or a
  few stocks, collars can help reduce risk
• The selection of the long put and the sold call
  allow an investor to select their own risk reward
  tradeoffs while controlling risk

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Outcomes Do Nothing

• Stock is not collared- Investor would continue to
  have unlimited upside with substantial downside
  risk

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Outcomes Collar with Call assigned

• Stock finishes in the money at expiration and
  investor sells their stock at the upside call
  strike price (best scenario), sell stock at 55
• Maximum value realized under collar strategy

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Outcomes Put exercised

• Stock falls and investor can exercise their put
  option, selling stock at the lower put strike
  price, sell stock at 40
• Minimum value created under collar strategy

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Outcomes Neutral stock movement at expiration

• Stock ownership is maintained with a small
  increased cost depending on initial debit amount
• Further consideration must be given to
  possibility of reentering the position in the
  future
• Alternatively the collar can be rolled forward to
  future months in the last couple of days prior to
  expiration if there is any time premium left in
  the shorter term options
• Neither minimum nor maximum realized

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Considerations for Collars

• Strike price- Must balance risk and reward and
  recognize your rights and obligations with the
  varying strike prices
• Time- Investors must choose the time frame they
  would like to protect and select that month

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Considerations for Collars

• Rolling- As time moves forward option theta
  reduces the option time values, investors can
  choose to roll your options to further out months
• Volatility- Option skew can sometimes alter these
  trades, option markets are efficiently priced and
  price in potential rapid price drops by
  allowing for higher put implied volatilities

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Option Skew??

• Option skew- Correlation between volatility and
  direction
• Normally volatility increases at lower prices,
  but by how much?
• Also called fat tails especially to the
  downside, stocks tend to drop faster than they
  rise

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Concerns

• Are you really willing to sell your stock at the
  call strike price or are you just trying to
  finance the put?
• Put skew develops in many stocks that hurts the
  economics of the trade. This creates a challenge
  as puts tend to trade at higher to slightly
  higher prices than calls based on implied
  volatilities (of course many professionals would
  contend that option pricing is very efficient)
• Skew is mostly determined by supply and demand
  factors from the marketplace

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Summary

• A long underlying position can be protected using
  the long put and short call position
• The selection of the strike prices for both the
  put and call depends on the amount of protection
  required
• Collars limit your upside but protect the
  downside
• The collar is a cheap protection method although
  this cheapness must be balanced against the
  obligations undertaken

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